Not so long ago, SPACs were fully-loaded locomotives barrelling down the IPO track at full speed. But things change, and SPAC exuberance is more tempered these days, a trend that a recent SEC rules proposal might reinforce further.
But that's not to say SPACs are about to go the way of disco and station wagons. After all, they still provide a unique, potentially beneficial alternative to a more "traditional" IPO route for issuers, at least under the right circumstances. However, before you venture down the special purpose acquisition company road, we wanted to look at the current state of SPACs and, just as importantly, what the SEC's proposed rules might mean for your future.
The State of SPACs: 2022 Edition
We'll spare you a deep dive into the underlying SPAC vocabulary and concept – blank check companies, SPAC sponsors, target companies, and whatnot. However, if you need a refresher course on the vernacular and prior SEC statements on SPACs, we urge you to look at our previous insights, SPACs: What's a Special Purpose Acquisition Company? and SPAC Warrants: What the SEC Statement Means for Accounting and Reporting.
With that out of the way, let's take a closer look at today's SPAC market. Needless to say, a lot has changed in a somewhat short amount of time. If you'll recall, SPACs were the talk of the town during the pandemic, with a record 613 SPAC listings raising a total of $145 billion in 2021 alone, constituting 147% and 91% jumps, respectively, from 2020's already gaudy numbers.
But 2022 has told a different tale thus far, clocking in at 58 listings as of April. Granted, that's still stratospheric compared to historical averages – roughly 23 per year from 2003 to 2019 – yet obviously down from where they once were. So what gives?
Although we could create a pretty lengthy list if we dug into market minutiae, we've narrowed everything down to seven primary culprits:
- A highly competitive market for a larger number of SPACs to find a suitable target
- Lackluster post-de-SPAC share performance
- Actual financial performance coming in lower, sometimes significantly lower, than the financial projections used in the merger proxy
- Lower volume of PIPE financings because of lower equity values
- Higher SPAC shareholder redemption rates
- Increased use of earnouts, often tied to stock performance
- Increased SEC scrutiny and time from merger signing to completion of de-SPAC, typically 5+ months
Obviously, with a more intense regulatory climate, the SEC's proposed rules could be salt on the veritable open wound for a SPAC market already reeling a bit. So on that note, let's examine what the fine folks at the US Securities and Exchange Commission are plotting for SPACs these days.
SPAC Goals: Key Areas in the SEC's Proposed SPAC Rules
As you know, brevity and the SEC aren't exactly BFFs. Why say something in 10 pages when you can say it in 372 of them? So, yes, the actual proposal – Special Purpose Acquisition Companies, Shell Companies, and Projections – is a heavy lift, one you're more than welcome to sink your teeth into.
Assuming you have better ways to spend your time, though, we've plucked out a few choice quotes that capture the document's spirit.
We are of the view that greater transparency and more robust investor protections could assist investors in evaluating and making investment, voting, and redemption decisions with respect to these transactions.
The proposed rules and amendments, if adopted, could help the SPAC market function more efficiently by improving the relevance, completeness, clarity, and comparability of the disclosures provided by SPACs at the initial public offering and de-SPAC transaction stages, and by providing important investor protections to strengthen investor confidence in this market.
See where this is going? Much like their ESG and cybersecurity reporting initiatives, the SEC is making a concerted effort to provide more transparency to investors, allowing them to make fully-informed decisions. At least in theory.
However, just look at any hungover scotch enthusiast to see it's absolutely possible to have too much of a good thing. In fact, the consensus from investors' initial sentiments on the proposed rules – especially retail investors – focuses on the SEC possibly overstepping boundaries and actually impeding the flow of SPAC deals.
Thus, to many, the proposal could hurt the very investors it's supposed to be protecting by limiting access to these initial public offerings. Remember, IPOs have historically been gobbled up by institutional investors, leaving most on the retail side high and dry. And that's not cool. So let's roll up our sleeves a bit and see what's under the hood of these proposed rules.
Enhanced SPAC Disclosures
Knowledge is power. And that's exactly what the SEC wants to provide with its proposed disclosure enhancements, spelled out in Subpart 1600 of Regulation S-K in the recent proposal if you’re in the mood for a jaunt through securities laws. Ultimately, the SEC's endgame is to provide investors with concise yet thorough and relevant insights – by way of enhanced disclosures – so they can better navigate the complex SPAC waters.
Sponsor Disclosures
Fair or not, many investors feel as if there's an air of secret handshakes and backroom negotiations around SPAC sponsors, probably stemming from misaligned incentives between sponsors and investors. Therefore, some of the new sponsor disclosures would include:
- The experience, roles, and responsibilities of the sponsor
- Any arrangements between the sponsor and the SPAC in determining whether to proceed with a de-SPAC transaction
- The nature and amount of compensation awarded to the sponsor, including any reimbursements paid upon the completion of a de-SPAC transaction
Since SPAC sponsors are typically compensated with roughly 25% of the SPAC IPO proceeds – paid upon the consummation of the de-SPAC transaction – the SEC wants to address potential conflicts of interest. In other words, they want to make sure sponsors don't enter into unfavorable de-SPAC transactions without performing robust due diligence just for a plump payday.
Thus, the SEC is also proposing required disclosures of any actual or potential material conflicts of interest between:
- A sponsor or its affiliates, or the SPAC's officers and directors, and;
- Unaffiliated security holders
Fairness of the de-SPAC Transaction
Mind you, these disclosures would be in addition to a proposed fairness of the de-SPAC transaction statement, speaking to whether the SPAC "reasonably believes that the de-SPAC transaction and any related financing transactions are fair or unfair to the SPAC's unaffiliated security holders, as well as a discussion of the basis for the statement."
Simply put, stating if the transaction is fair or unfair isn't enough. The proposed statement would also require SPACs to support the logic and basis behind the conclusion, possibly even providing a third-party fairness opinion.
Sources of Dilution in SPAC Transactions
Another critical area in the proposal focuses on new required disclosures concerning dilution. In essence, the SEC is concerned about the many potential sources of dilution in a SPAC structure. In particular, certain costs can significantly dilute the investment for shareholders, especially those that don't redeem their shares and, thus, remain invested in the combined public company. The most obvious of these dilutive costs include:
- Underwriting fees
- Shareholder redemptions
- Sponsor compensation
- Outstanding warrants
- Convertible securities
- Private investment in public equity (PIPE) financing
Zooming in a bit further, the SEC is proposing additional disclosures in SPAC registration statements that would require a description of material sources of further dilution following the SPAC's IPO. The proposal also requires a tabular disclosure of future dilution from the IPO price that non-redeeming SPAC shareholders would absorb, or at least to the extent it's quantifiable.
Other Proposed SPAC Rules and Disclosure Requirements
Even the SEC can't pontificate exclusively on proposed disclosures for 372 pages. We think. To that point, the proposal discusses other new requirements that would be front and center in a SPAC transaction.
Financial Statement Requirements
The SEC proposal includes changes to business combination transactions involving shell companies, which obviously includes SPACs in this case. Specifically, the proposed changes would better align the financial statement requirements of private operating companies in SPAC transactions with those required in a traditional IPO.
Except when specific scenarios permit just two years, these changes would require three years of:
- Income statements
- Changes in stockholders' equity
- Cash flows
The proposal includes some relief in this area as well, provisions not in the current requirements. On that front, the SEC has expanded the scenarios where only two years of financial statements would be required by removing language speaking to whether the shell company – the SPAC – has already filed its first annual report.
Application of Rule 3-05
In addition to financial statement requirements, the SEC is also proposing a new rule for businesses acquired by the target private operating company. The proposed rules would apply S-X Rule 3-05 to acquisitions by the target private operating company – the predecessor entity in most cases – because it is deemed a ‘co-registrant’ in the proposal.
Just in case you need a refresher, Rule 3-05 relates specifically to financial statements of an acquired business or probable to-be-acquired business. The rule dictates that a registrant is to provide separate audited annual and unaudited interim pre-acquisition financial statements of the business if it’s significant.
Speaking of significance, the proposed rules also modify the Rule 3-05 significance tests by requiring use of the operating company’s financial information in the denominator versus the shell company’s financial information. Using the private operating company’s financial statements for the denominator is intended to yield results that recognize some acquisitions are more significant and have a greater effect than others consistent with the intent of the application of Rule 3-05.
Financial Projections
Financial projections have traditionally played a vital role for investors in many SPACs and IPOs, with the forward-looking information providing a beneficial – yet hypothetical – peek down the road.
As you would expect, the SEC proposal also includes changes to the use of projections. With these enhancements to disclosures, the SEC aims to address issues around projections in de-SPAC transactions that may lack reasonable, material bases. Digging a bit deeper, the SEC staff wants to mandate additional disclosure requirements to "enhance the attention and level of care companies bring to the preparation of financial projections."
The proposed changes will provide guide rails for registrants to present projections in an appropriate format and context, helping investors evaluate the projections and assess the reasonableness of the projection basis. In the end, the SEC wants investors to know when and how much to rely on these financial projections.
Target Operating Company Form S-4 Changes
Currently, non-financial information on the target operating company is due within four business days of completing the de-SPAC transaction, commonly known as a Super 8-K. With the proposed rules, this Super Form 8-K would be due earlier and be provided within the Form S-4, giving shareholders critical information on the operating company before making any voting and redemption decisions.
Co-Registrants on Form S-4
As we mentioned earlier, the proposal would also treat the SPAC and target company as co-registrants on Form S-4. This way, with the private operating company as a co-registrant, the business and any signing persons would be liable for any material misstatements or omissions, theoretically mitigating the risk of inaccurate or materially misleading disclosures by holding the target company accountable.
Smaller Reporting Company (SRC) Status
The SEC also wants to require the post-business combination company to redetermine its SRC status following the completion of the de-SPAC transaction. Right now, most SPACs qualify as SRCs and retain that status until the next required annual determination date. The proposal would change this, requiring the combined business to reflect the redetermination in its first periodic report, like a 10-Q, for example.
Defining a Blank Check Company
The SEC also wants to amend the definition of a blank check company under the Private Securities Litigation Reform Act of 1995 (PSLRA). This change would clarify the statutory PSLRA safe harbor under the Securities Act of 1933 and Exchange Act of 1934, reaffirming the safe harbor is not available for forward-looking statements made by SPACs – like projections of the target operating company, for instance – while also subjecting them to potential liability.
Investment Company Act Safe Harbor
Speaking of safe harbors, the proposal includes a safe harbor provision under the Investment Company Act of 1940, stating a SPAC would not be considered an investment company if it meets all of the following conditions:
- A SPAC's assets only consist of government securities, government money market funds, and cash.
- SPAC activities are limited to a single de-SPAC transaction, resulting in a surviving public entity primarily engaging in the business of the target company or companies. The surviving entity must also have a class of securities registered on a national securities exchange.
- Activities of a SPAC's employees, officers, and directors must primarily focus on seeking a target company. The SPAC's board of directors must also adopt an appropriate resolution for this business purpose.
- A SPAC announces a business combination within 18 months of an initial public offering, completing the combination within a 24-month timeframe from the IPO.
Mind you, these conditions are a rule of thumb and don't necessarily mean SPACs that fall short automatically fall under the investment company moniker. As always, you should check with a trusted M&A financial advisor or capital markets advisor to clarify further. Better safe than sorry, right?
Underwriter Liability
Lastly, the SEC proposal would require SPAC IPO underwriters to extend their underwriter status to the de-SPAC transaction. In the SEC's own words, the proposed rule should "better motivate SPAC underwriters to exercise the care necessary to ensure the accuracy of the disclosures in these transactions by affirming that they are subject to Section 11 liability for that information."
Where Do We Go from Here?
Of course, proposals are just that – proposals. Still, with the public comment period likely closed once this bountiful tome lands on Embark's website – the proposing release hit the Federal Register on May 13, 2022 – it will be interesting to see how the more pointed commentary impacts the new SPAC securities laws when the SEC deliberates the proposal.
Thus, things can and probably will change between the proposed and finalized rules, at least in some capacity. But as always, Embark's team of specialists will be here to walk you through the changes as they unfold. So stay tuned, and if you have questions along the way, just give us a holler.
